Probability analysis makes a better financial trader

Following the probability analysis approach favoured by legendary investor Warren Buffett can help you to become a first class financial trader.

Buffett’s biographer Alice Shroeder has said: “Most people find an interesting idea, they figure out the math, the financials, the projections, and then in the end, they ask themselves: okay what could go wrong? Warren starts with what could go wrong.”

Probability analysis is a catch-all term for looking at historical performance and working out the likelihood of that performance being repeated in anticipated conditions. It is dull and risk-averse, but can prove incredibly profitable.

Warren Buffett: Shutterstock.com

Punching above your weight

This approach can be seen from an example early in Buffett’s career. As part of a court case, IBM was forced to divest its business that made the punch cards that programmed the early mechanical computers.

Two of Buffett’s friends saw an opportunity to compete with IBM and set up a company called the Mid-Continent Tab Card Co. They invited Buffett to invest but he declined. It was a start-up business competing with IBM.

A year later in 1959 the friends approached Buffett again. Their business was producing 35 million punch cards a month and they needed money to buy more of the Carroll presses that produced the cards.

This time Buffett was interested because the company had now proved it could compete successfully with IBM. It also had a year’s worth of figures that Buffett could analyse.

Warren starts with what could go wrong

by Alice Shroeder

Horsing around

Buffett had an early interest in horse race handicapping and applied a similar technique to the tab company. What could make this ‘horse’ succeed or fail? Sales growth and a continuing cost advantage.

He looked at the historical data for all the company’s plants and compared it with data from its competitors to make his decision. The Mid-Continent Tab Card Co was making 36% returns on annual sales of one million and was growing at a rate of 70% a year.

To invest Buffett wanted a return of 15% on sales of two million. With the company making returns of 36% there was a large margin of safety and Buffett duly invested. He held the investment for 18 years, earning a 33% compounded return.

The Berkshire Hathaway approach

Buffett has explained his approach in more detail in letters sent to the shareholders of his company Berkshire Hathaway. Ones from 1977 and 2007 say virtually the same. In 1977 he said:

“We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be:

In 2007 ‘attractive price’ had changed slightly to ‘sensible’. That year’s letter also mentioned the need for a ‘moat’ to protect returns on invested capital as competitors of a company earning high returns will repeatedly try to get across the moat to attack the castle.

The letter says, “being the lowcost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with ‘Roman Candles,’ companies whose moats proved illusory and were soon crossed.”

Becoming a better financial trader

Berkshire Hathaway’s principles can be applied to your own investing to make you a better financial trader.

Invest in companies where you understand the business model and can see how the industry works. So if your IT knowledge is limited to turning your computer off and on again when something isn’t working properly, tech stocks are probably not for you.

Berkshire Hathaway has strong investments in areas Buffett understands, such as consumer products.

Look at the long-term prospects of the company. What is the competitive advantage? Is the business likely to continue or will a new way of doing things sweep the industry away? Will it go the way of video rental shops, such as Blockbuster, when people starting downloading or streaming films at home?

Longevity

Businesses that people still need when times are tough are likely to be a good investment. So utilities are a much safer option than luxury goods companies.

See who runs the company. Do they have a good reputation? What would happen to the company if they left or were involved a scandal? Buffett warns against investing in a company built around one individual.

What is the value of the company on the stock exchange? How does this compare to what you think the company is actually worth? Is it trading at a discount? Looking at what could go wrong for a company using probability analysis is a good way of ensuring that the investments you choose earn the returns you expect.

Probability of success

Not every financial trader can be a Warren Buffett and, as the name ‘probability analysis’ suggests, nothing is certain in investing. But with the right groundwork, money is there for the making.

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